Employee Stock Option At Microsoft Corporation

1. Value the 70 million Microsoft options granted in April 2000 if T=6 years Using Black-Sholes. a. K=66.625; So = 66.625 b. rf = 6.2% ; = .33
Call Price Number of options shares outstanding m/(n+M) Value of options(with dilution) Value of options(without dilution) $ $ 29.73 70,000,000.00 5,283,000,000.00 0.99 2,053,878,802.12 2,081,092,793.44

2. Value the 70 Million stock options granted in April 2000 if T is distributed as follows. a. 10% at 4 years, 20% at 5 years, 40% at 6 years, 20% at 7 years, and 10% at 8 years. b. Use the variable from 1(a) and 1(b) T
4 5 6 7 8 Tota l
Number of Options Options Price Value without Dilutions m/(m+n) (5 different) Value(with dilution multiple values) m/(m+n) (single value) With Dilutions (single Value)

7,000,000 14,000,000 28,000,000 14,000,000 7,000,000 70,000,000

$23.68 $26.87 $29.73 $32.32 $34.69

$165,754,506.65 $376,155,428.86 $832,437,117.38 $452,532,734.01 $242,837,653.38 $2,069,717,440.27

0.9987 0.9974 0.9947 0.9974 0.9987

$165,535,171.77 $375,161,248.00 $828,048,444.95 $451,336,687.51 $242,516,318.11 $2,062,597,870.33

0.99 0.99 0.99 0.99 0.99

$163,586,971.54 $371,236,527.30 $821,551,520.85 $446,615,063.28 $239,662,118.96 $2,042,652,201.93

3. Recalculate the values in #1 and #2 using the following observed volatility a. The historical volatility of Microsoft stock calculated using daily returns data in 1999: Daily volatility = 2.40% and Annual Volatility = 38.09% Number of Options T Options Price Value
Call Price Number of options shares outstanding m/(n+M) Value of options(with dilution) T= 6 Value of options(without dilution) T= 6 32.01 70,000,000.00 5,283,000,000.00 0.99 $2,211,535,690.15 $2,240,838,642.70

4 5 6 7 8 Total

7,000,000 14,000,000 28,000,000 14,000,000 7,000,000 70,000,000

$25.79 $29.08 $32.01 $34.64 $37.02 Total Value

$180,522,877.40 $407,189,822.86 $896,335,457.08 $484,963,608.77 $259,128,750.61 $2,228,140,516.72

b. The historical volatility of Microsoft stock calculated using daily returns data in 2000-2005: Daily volatility = 2.35% and Annual Volatility = 37.29%
Call Price Number of options shares outstanding m/(n+M) Value of options (with dilution) T= 6 Value of options (without dilution) T= 6 31.66 70,000,000.00 5,283,000,000.00 0.99 $2,186,881,352.90 $2,215,857,634.31

T 4 5 6 7 8 Total

Number of Options 7,000,000 14,000,000 28,000,000 14,000,000 7,000,000 70,000,000

Options Price $25.46 $28.74 $31.66 $34.28 $36.65 Total Value

Value $178,212,580.43 $402,335,808.32 $886,343,053.73 $479,892,982.28 $256,582,061.88 $2,203,366,486.64

Binomial Model 4. Use the binomial to perform the valuation in question 1 with the following assumptions: a. Assumed that each step is three years so that you have two steps for T=6 years

b. Value the options using the up and down steps matching the volatility you use in the Black Sholes valuation in #1. Keep the riskfree rates and volatility constant.

Price
66.625

K
66.625

rf
6%

T
6

T
3

0.33

U
1.771057
2

D
0.564634

P
0.530318

(1-P)
0.469682

K
66.625

fuu
142.35

2p
1.06

(1-p)
0.47

fud
0.00

(1-p)
0.22

fdd
0.00

[-2r*(Delta T)]

0.2812

0.69

Option Value $27.60

5. Value the options after changing the following assumptions (hold everything else constant) a. Use the following risk-free assumptions: (keep everything else constant) i. Increase risk free rates ii. Decrease risk free rates Years 1-3 rf 6% 6% 6% Years 4-6 rf 1% 6% 11% Option Value $23.66 $27.60 $30.99

b. Use the following volatility assumptions: (keep everything else constant) i. Increase volatility ii. Decrease volatility Years 46 () 0.13 0.33 0.53

Years 1-3 () 0.33 0.33 0.33

Option Value $ 27.60 $ 27.60 $ 34.22

6. Summarize how sensitive the options valuation is to the following assumptions a. Fixed Expiration Date Holding all other variables constant, using a fixed expiration date instead of multiple expirations dates causes the valuation of the total option price to increase which somewhat makes sense because now there are time periods (4, 5) which are less than the fixed expiration date (6) and they seem to be disproportionately affecting the option value. Looking at the values in Question 2 above, you will notice that option price is increasing for T = 4, 5 8 which makes sense since having more time allows for greater flexibility in when to exercise an option and gives you a better chance of being in the money.

b. Fixed Risk Free Rate Holding all other variables constant, increasing the risk free rate from one time period to the next in the two step binomial model caused the value of the option to increase. On the other hand, decreasing the risk free rate from one period to the next in the two step binomial model caused the value of the option to decrease. This is in accordance with options related theory which expects such behavior from option prices.

c. Fixed Volatility Holding all other variables constant, increasing the volatility from the first time period to the second in the two step binomial process causes the option price to increase which makes sense because increasing volatility increases the value of an option in the Black Sholes model. However, decreasing the volatility from the first time period to the second in the two step binomial process results in no change in the option price.